A Gap Between Candles is a phenomenon on a chart where there is a small or significant empty space between two candles. This is an important element used by traders in candlestick analysis to predict the upcoming trend and identify good entry points for a position.
Gap Between Candles in the Derivatives and Stock Markets
Gaps in the stock market and derivatives market differ in their causes. In the stock market, gaps often occur due to trading sessions. Since liquidity is much lower during pre-market and after-market hours, stock prices can change abruptly between sessions due to the release of news or reports.
In the derivatives market, gaps form for different reasons. One of the key factors is expiration. For example, when transitioning to a new contract, prices can vary significantly due to changes in market conditions, volatility, or liquidity. Additionally, gaps can be caused by movements in the underlying asset or low liquidity during off-market hours.
Main Types of Gaps
There are countless “types” and names for gaps found in various sources. However, ultimately, the most important types of gaps in trading are Gap Up and Gap Down, as they reflect changes in market dynamics and participant sentiment. Understanding these patterns helps traders use candlestick analysis to identify potential entry or exit points in the short-term or medium-term.
Gap Up refers to a situation where the asset’s price opens higher than its closing price on the previous candle. This indicates strong demand or a positive market sentiment. This candlestick pattern is often associated with news releases, positive economic data, earnings reports, or strong buying interest. Gap analysis helps determine whether the market will sustain this rise or retrace to previous levels.
Gap Down occurs when the price opens lower than the high and low price of the previous candle. This often signals a negative market sentiment, reduced interest in the asset, a poor earnings report, or bearish news. Candlestick patterns such as a bearish body help determine whether this gap will develop into a trend or be closed due to a short-term rise.
Using Gap Analysis
Traders can use gap analysis to determine whether the current gap between candles is short-lived or if it will develop into a new trend. These types of gaps also reflect important support and resistance levels.
How to Trade Gaps: From Intraday to Medium-Term?
The methods for trading gaps are fairly simple yet effective. However, market sentiment must be taken into account. Sometimes, poor economic data or a disappointing report can bring unexpected positivity to the market. Conversely, with good data, news, or earnings reports, investors might take profits, causing the stock price to fall. A good example of this situation was the 2023 labor market data in the U.S. The data came in worse than expected, yet the market continued to rise. Why? Because in such cases, it becomes another factor for the Federal Reserve to lower interest rates, which is good news for U.S. stocks.
Gap Trading for Swing/Medium-Term Traders
Medium-term and swing traders use the “gap testing after earnings” strategy. The price often tries to “close” or test the gap. These levels then act as future support and resistance for the price. The position should be opened in the direction of the gap. If it’s a Gap Up, a long position is opened; if it’s a Gap Down, a short position is opened. The stop loss should be set either at the gap closing point or at a local high or low of the price.
In the example above, buy and sell points in TSLA stock after Gap Up and Gap Down are highlighted. The positions should be held from one week to a maximum of a quarter. It is better to close the position before the next earnings report, even if it’s in the red. This is because even good reports can lead to a Gap Down, and vice versa, which introduces unnecessary risk.
A reasonable question arises: “Where should the stop loss be placed?” As mentioned earlier in the article, the stop loss should be set either at the gap closure point or at the local price high or low. To better understand this paradigm, look at the image above, where stop loss levels for the same positions in TSLA stock are marked.
An observant reader will notice that in the TSLA stock example, there is a gap zone where the position was not opened.
There are reasons for this: The quarterly earnings report for Tesla was due 12 days after the marked Gap Down. On the daily chart, the price closed 7 consecutive red “doji” candles. This indicates weak selling pressure.
Therefore, a short position in this case is too risky. Even if a trader opened it before the price closed 7 red doji candles, it’s better to exit with a small profit or at break-even.
Day Traders
For day traders, trading Gap Up and Gap Down is a bit more complicated than for swing or medium-term traders, as intraday volatility is significantly higher. However, the trading logic remains the same. Open a position in the direction of the gap. If it’s a Gap Up, open a long position; if it’s a Gap Down, open a short position. The “noise” level is relatively high, so trading should only occur when the price has clearly determined its direction.
In the example above, after the close, a Gap Up formed on the Post and Pre Market. After the opening, the price moved upwards. After a small pullback, an intraday trader could open a long position (the entry point is marked with an arrow). In this case, the stop loss is set at the opening price or the day’s low.
It’s worth closing the position in the marked zone for several reasons:
Timing – In the second half of the day, trading volume drops significantly, and towards the close of the main trading session, it increases again. This moment increases volatility exponentially.
Risk/reward ratio is 1:2. This is the golden ratio for an intraday trader.
The peak begins to round off. This is a signal of weakness in the current local trend.
Conclusion
Gap between candles is a powerful tool that helps traders analyze the market and predict price movement. By using candlestick patterns, gaps, and other elements such as support and resistance lines and market trends, you can better understand market sentiment and make more informed decisions. It’s important to remember that gap analysis requires a comprehensive approach, including both technical and fundamental analysis.
If you want to improve your candlestick trading skills, pay attention to gaps, their significance, and how they align with other market signals. These tools help traders successfully navigate the market and increase the percentage of profitable trades.
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